Estimating the Relationship between the Current Account, the Capital Account and Investment for India

Causality from the capital account (KA) to the current account (CA) of the balance of payments indicates disruption from capital flows while the reverse can indicate smooth financing of the CA that allows investment to exceed domestic savings. A three-variable vector auto regression tests for Granger causality between the Indian CA, KA, KA components, and gross fixed capital formation (GFCF) over 2000-01Q1 to 2015-16Q3. Since a current account deficit indicates an excess of investment over savings it is useful to estimate which type of capital flows affect investment. No causality is found to exist in any direction between the KA and the CA. There is only indirect causality through some components. Of the capital flow components only FDI affects GFCF. The latter consistently affects the CA. The CA affects debt portfolio flows and non-resident deposits, suggesting these were used to finance the CA, but they were not causal for GFCF. Volatile flows therefore did not deteriorate the CA, but they also did not contribute to GFCF. India's gradual capital account convertibility may have mitigated shocks from the KA. Long-term sustainability, however, requires FDI to increase compared to other types of flows.